Summary
- Gold prices have been in a bear market since the August 2011 peak at $1920
- Prices are making new 52-week lows
- Gold has primarily been a monetary asset throughout history and moves closely with the global monetary base (GMB), the sum of the U.S. monetary base and total international reserves
- Gold has lost some of its luster as a store of value as goods and services inflation failed to materialize after the printing presses flooded the global economy with trillions of reserve currencies during Great Financial Crisis
- Surprisingly, demand remained steady or even increased as the major central banks emitted trillions in new currency
- The broken credit mechanism resulted in an overall monetary contraction and shortage of dollars
- The gold bugs had their day as gold moved 650 percent from August 1999 to August 2011 while the GMB moved 455 percent during the same period, the result, mainly of a massive build in international reserves
- The global monetary base will continue to contract over the next several months as the Fed shrinks its balance sheets and emerging markets continue to lose international reserves
- Gold prices will thus linger and drift down toward and below $1,000 unless a major global shock results in a flight to quality
- Just as the simultaneous unfolding of umbrellas do not cause but, instead, reflect a reaction to similar external forces – rain; so to do comovements in the dollar and gold. In other words, moves in the dollar do not cause moves in gold but reflect a reaction to similar external stimuli
- The next round of QE, which will probably be the result of a G7 sovereign debt crisis, should cause the massive spike in gold prices that the bugs were looking for in round one
- We could be wrong
Gold is making 52-week lows.
The yellow metal has been in a vicious bear market, down almost 40 percent since its September 2011 high of $1,920. We find it almost impossible to make money in the commodity, much like everything else in trading these days, at least for us.
Close your eyes and BTFD and let it ride! That trade is only working now in just a few stocks.
Only Buying French Dips
After taking some big hits and several small ones, we have disciplined ourselves to buy only French Dips these daze. We are not comfortable trying to pick up pennies in front of a steamroller.
Everything is expensive and it is even more difficult to time the bursting of price bubbles driven by restricted supply rather than leveraged demand, such as was the case n 2008 credit and housing bubble.
Furthermore, with the algos looking to pick you off 23/5 it is even becoming impossible to scalp to make money in a range trading market.
Cash flow is getting tight and we can’t decide if our next career is a truck driver or python programmer. Have any thoughts?
Enough of the ranting.
Helicopter Ben
On October 24, 2005, President George W. Bush announced he was nominating Ben Bernanke, his chief economic adviser at the CEA, to replace Alan Greenspan as the next Fed chairman. The gold price was trading at around $470.
I noticed Boeing stock was up over 2 percent, and Boeing made the AH-64 Apache helicopter. I instantly thought how efficient the markets were that helicopter stocks were rocking the same day “Helicopter Ben” is nominated as the Fed chairman. Genius!
I instantly shot off an email to my now famous friend, Barry Ritholtz, pointing this out and he made it his QOTD – quote of the day. True story.
Thank Goodness For Gentle Ben
In all seriousness, we complain here a lot about irresponsible monetary policy and the serial bubble blowers at the Fed, but we are grateful Bernanke was the Fed Head during the Great Financial Crisis (GFS). Even if he did play a major role in contributing and missing the massive housing and credit bubble.
I am sure most of you would agree it’s much better living with the consequences of a too loose monetary policy than living under a freeway and eating bark for dinner.
Anyone in the know and close to the situation in 2008/09 understands how close we came, and several times, and within minutes, to a complete financial and economic collapse.
Marshall Law
I am not talking about 50 percent clipped off the Dow but a complete collapse of the global payments system, marshall law, the hijacking of food trucks, food riots, and wars.
We came very, very close to the apocalypse, folks.
Ignorance was bliss back in the Q4 2008 but those in the know spent many nights without sleep hyperventilating.
Unfortunately, it doesn’t seem we have learned our lesson and the final chapter has yet to be written. It seems as if asset bubbles are the only tool to keep the global economy afloat these days. No wonder the Fed wants to keep trillions of excess reserves in the system by paying banks not to lend them out.
What Drives Gold Prices
So what are the factors that drive gold prices over the medium and long-term?
There is really no metric to determine the equilibrium price of gold. such as a price-earnings ratio. Gold has little industrial use and has mainly been a monetary asset throughout the ages.
We wrote back in 2010, just before the 55 percent blow-off over the next 12 months,
Because the equilibrium price of gold is an unknown, the yellow metal keeps running. There is no real metric to determine its fundamental value — a real rate of interest and price-earnings or price to book ratio, for example. This is also the case with most commodities. And, in a world of zero interest rates, the opportunity cost of holding gold is extremely low.
…Nobody knows the “right” price and that is why the commodity, in our opinion, will surprise to the upside.
..Some say Gold is nothing more than a fear trade.” We agree: we are afraid when we are too long, not long enough, or not long at all! – GMM, Sept 25, 2010
Fundamentals
After many years of watching and trading gold, we have concluded that, because it is a monetary asset (the Russians are selling dollars to add to their gold reserves), gold moves closely with what we call the global monetary base (GMB). That is the sum of the U.S. monetary base and total global international reserves excluding gold.
We can’t recall where or how we came up with calculation of the global monetary base and will get back to you as soon as we do. Ed Yardeni does a great job tracking the global monetary aggregates, however.
When we have more time we may revise the data and add a portion of the ECB monetary base to the global monetary base as the euro now makes up a growing portion of international reserves. The dollar is still around 65 percent of total reserves.
Peak Global Monetary Base
The global monetary base peaked in August 2014 about two years after the the gold price peaked. We think because the rapid increase in base money didn’t result in the goods inflation as many believed, including us, by the way, gold has lost much of its luster as a monetary asset and paved the way for rise of cryptocurrencies.
We understood, maybe not as well as we should have, that the credit mechanism was broken and the increase in traditional base money would not translate into a rapid increase in the monetary aggregates causing demand pull inflation. We failed to believe, however, the markets would be willing to hold dollars after such massive monetary emissions.
We extrapolated our experiences from the emerging markets such as Venezuela and Argentina, and failed to believe the demand for the reserve currencies would actually increase and dollar shortages would break out due to the contraction of credit.
Gold Disappoints
After waiting for their moment for so long, the gold bugs didn’t get what they were looking for, at least not yet. Inflation didn’t emege and gold didn’t perform, and now just wanders and lingers, seemingly waiting for the next monetary burst.
We do believe the next round of quantitative easing may be a different story, however, as it will probably occur simultaneously with a sovereign funding crisis in a G7 country. Central banks will be called upon to fund the inability of a sovereign borrower to rollover its debt. Much like what happened during European debt crisis in 2011 but on a larger scale, such as a big debtor like Italy getting into trouble. The currency then becomes “hot potato” money as demand dries up and the potential for hyperinflation increases.
Increase In Total International Reserves
It is interesting gold began to move when total international reserves started to expand in the emerging markets in the late 1990’s. The EM governments learned after the 1995 Mexican Peso Crisis, the 1997 Asian Financial, and 1998 Russian debt default that allowing hot money to cause currency appreciation — though holding down inflation and creating “wealth effect” driven growth — was a recipe for a balance of payments and current account crisis.
The change in foreign exchange regimes across the emerging markets to more of a “dirty float” mechanism where central banks intervene in the FX markets to keep their currencies competitive led to a massive build in international reserves. It makes sense that gold would rise just from the increased demand from the “allocation effect.” Some countries try and keep a certain percentage of their international reserves in gold.
Asset Bubbles And The New Economy
We have noted several times that everything changed in the 1990’s as assets markets began to grow increasingly overvalued, and actually drive and lead the economy rather than follow it. The big inflows and recycling of the massive build in international reserves back into U.S. financial markets was a major factor contributing to that change.
Gold Price And The Change In Global Monetary Base
Finally, we have charted the monthly gold price to the first difference change in the global monetary base. As the chart illustrates, the two track relatively well. They both peaked around the same time and have been doing nothing ever since.
China RMB
The global monetary base has been contracting over the past few months as emerging markets have been losing reserves due to currency weakness and the Fed has been reducing the monetary base through its balance sheet reduction. No surprise gold has been weaker.
China holds a little over 25 percent of the world’s international reserves.
As President Trump said today China’s currency “has been dropping like a rock.” The RMB is only down about 2 1/2 percent in July, hardly a rock, such as the Turkish “kaya”, which is down 5 percent in the same period.
It’s difficult to determine whether China is weaponizing the RMB in the trade war with the U.S. or capital flight is causing the weakness and the PBOC is losing reserves trying to cushion the fall. If so, it could explain the recent weakness in gold.
Conclusion
Keep the global monetary base, both the U.S. base and total international reserves on your radar, especially the first difference change in the GMB. You will be amazed how closely they track each other over the medium to long-term.
It will also give you more confidence in your view as noise and volatility increase. Gold is a treacherous market to trade.
The relationship will be noisy as is everything else. Gold can suddenly spike. It is still considered a safe haven in times of turmoil.
We expect the GMB to continue to shrink over the next several months and wouldn’t be surprised to see gold dip below $1,000 per ounce.
Stay tuned.
Global Macro Monitor 